This is the summary of Episode 5 of our Roaming Returns Podcast.
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Podcast Summary
Please bear with us, this is still in progress.
Bonds are one of many types of assets that every investor needs to consider when developing their investing strategy.
They can work quite well when used for income if you buy them right which we’ll get into a little later. The term dates can also be a benefit or pain depending.
Types Of Bonds
Corporate
Municipal – local governments these have tax advantages. Ex New Jersey Transit system has a lot of tax free bonds for state residents.
Treasuries – considered the safest T-Bills and Tips
Government agencies – FIMA, education system, mortgage system,
Reasons To Buy Bonds – The Pros
Bonds Provide A Reliable Fixed Payout
When you buy a bond you know exactly how much and when you’re getting paid. You take the par value times the coupon rate and divide it by 2 since they pay out twice a year.
Many people think Bonds are less risky than Stocks but that entirely depends on the type and grade that you buy.
*make separate post for bond ratings and risk of default
Bonds Are Great For Portfolio Preservation
If you’re in retirement or are a low risk investor, then bonds are a great way to keep your portfolio value in tact. Bonds don’t fluctuate in price very much especially compared to stocks.
Bonds Have The Highest Priority Payouts
Bonds are generally the last type of asset to cut their payouts. The common shares and preferred shares get cut first. And even if a bond’s payout gets suspended, they will pay you the cumulative amount missed on the next one they pay out.
Bonds Are Really Easy To Valuate
The Par Value for a Bond is 100. Anything over that and you’ll be overpaying. Anything under it you’ll be underpaying. We’ll show you way you never want to pay above par value down in the strategy section.
The Cons Of Bonds
Risk Of Default
The lower grade bonds you buy the higher the risk of default you’re incurring. If you buy below a BBB- you enter the junk bond arena. Insert youtube clip of the junk bond kings of the 80s.
Junk bonds are super risky. If they default you lose everything. It’s like a stock going to zero. This is why you need to do your research when buying bonds.
You Need To Shell Out $1,000 For 1 Bond
If all you have to invest is $1,000 you can’t diversify to hedge your risk. We much prefer lower cost assets where you can buy many shares for the same amount of money.
This doesn’t mean that we never buy bonds, but we’re much more selective and the economic climate matters a lot.
Risk Of Company Downgrades
If a company gets downgraded in the grading system, people do exactly the same thing as bad news in a stock. They freak out and panic. When they panic the prices of a bond can plummet.
Lose Value When Interest Rates Go Up
Because Bonds have terms that lock you in, rising interest rates cause the value of your bond to go down. When company needs to issue new bonds, they’ll issue them at the current interest rates.
You either need to hold with the less ideal rate, or sell your bond at a loss to invest the money in better yielding assets.
Who knows what the market climate or opportunities will be available when long-term bonds free up your money. It’s hard enough to predict short term economics. This is the number 1 reason we don’t invest in CDs. But there are some ways around this in bonds.
You can get more short term bonds, but the interest rates are terrible.
Risk Of Callbacks
If interest rates go down and you’re holding a high interest bond a company may do a callback at par to issue new bonds at the lower interest rates.
This is a major reason to NEVER buy bonds above par.
You Lose Money When Selling Before Maturity
If you buy a bond and sell it early, you’re going to sell it for less than the listen values. Tim has sold so many and this always happens regardless of whether he has a limit or not.
This is either a hidden fee or penalty for selling a bond before maturity or there’s built in slippage for market makers to match buy and sell orders.
Illiquid
Because bonds have term dates, you’re money is locked up. If you need more liquidity, bonds are not the ideal asset to invest in. Worthy Bonds in a great alternative.
Even when you’re buying and selling bonds, they price spread is usually bigger which makes them time consuming to get in and out of.
Infrequency Of Payouts
Only payout 2x a year
We consider the infrequency of payouts to be a negative as income investors since we want monthly payouts. A way around this is to ladder your asset payouts so they even out throughout the year.
DRIP Is Unavailable
Bond interest payouts are not eligible for automatic reinvestment which means you have to manually reinvesting yourself to compound your returns.
If you don’t keep up with your portfolio and there’s a lag between when you reinvest that money, this would cause you’ve lost some earnings.
A Pain To Do Research And Buy In Most Exchanges
Some exchanges make it extremely difficult to research bonds… looking at you Vanguard. Tim says it’s like trying to read Chinese. Schwab is a breeze in comparison.
Your chosen brokerage account can make your life harder or easier so choose wisely.
Bond Strategies
If you implement the right strategies, you can make buying bonds profitable and negate some of the negatives that come along with this asset class.
Use Laddering
If you need to have consistent income on a monthly basis you can buy assets strategically so that their payouts are staggered for the ones that don’t pay out monthly. This will enable you to try to minimc or at least get a close monthly payout amount.
*insert illustration
you can do the same thing with quarterly and other stuff.
screen shot with schwab even payout chart.
Buy A Fund Instead Of Individual Bonds
There are many bond funds, but you have to do your research on which ones are good. A major one that keeps popping up in the books Carmela reads is Vanguard’s Total Bond Index Fund VBTLX (<– ass compared to a new find PDI).
But the major problem with the index funds is that they don’t pay high enough dividends for our liking. Tim has us invested in DSU which is a fund that invests in bond and pays a ~10% dividend yield.
Funds tend to have more fees, so that’s why you need to buy them undervalued and the dividends need to be worth it. Otherwise the fees each up your profits.
Always Buy Bonds At A Discount
The best time to buy bonds is when they’re undervalued. Tim noticed when they were selling at 20-40% discounts to Par Value and bought some quality bonds in Carmela’s mom’s retirement account.
He then holds them while collecting interest until they get back to Par Value or above Par Value before selling them off. This allows you to get a big valuation increase while collecting dividends.
Bond prices go down when interest rates go up because new higher bonds are more valuable. This happens in reverse when interest rates come down and corporations call back their higher interest bonds.
This takes about 2-3 years and negates the term date issue.
Buy Below Par –> Collect Payments –> Sell At Or Above Par
Tip
Sometimes municipalities and governments default on Munis which ends up in the news and drives down prices of the whole sector. These make great buying opportunities while everyone else is scared.
Muni Bonds Pay Higher Because Of Less Taxes
Most people compare interest rates like they’re apples-to-apples, but that’s not the case if you end up getting tax advantages from a Municipal Bond if they live in the same state.
We suggest you talk with your accountant for the best advice in this realm.
Invest In Alternative Assets That Work Similarly
Closed-Ended Funds
One of Tim’s favorite types of assets are Close-Ended Funds or CEFs. They may not have the level of security that bonds do, but they have so many other things going for them.
CEFs are often considered to be a fixed-income asset which is the same category that bonds are in. They even have a NAV Price, which works the same way as a bond’s Par Value.
CEFs usually pay monthly too which we love. They also have higher interest rates than bonds and you can buy and sell them whenever you want at the price you want. DSU mentioned above is a Close-Ended Fund.
If you want more details check out Episode 16 where we go deeper into Close-Ended Funds.
Worthy Bonds
Worthy is a company that lends money out to small businesses and pays you interest. It’s outside the stock market and is a fixed-income investment vehicle, but it doesn’t have term dates.
Each bond is only $10 and interest automatically reinvests to buy a new bond anytime you get an extra $10. They even allow you to link your debit card and do round-ups.
It’s our absolute favorite place to keep our emergency fund. If you want more information check out Episode 6 where we cover all the deets.
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